Static Fed: No Hike, But Rise Likely Ahead Even As Business Investment Slows

As widely expected, the Fed left rates unchanged at its November meeting, setting up what looks like strong odds for a final hike next month. Its statement cited continued economic strength, but observed that business fixed investment seems to be moderating.

Key Takeaways

Fed statement mostly unchanged, but does note a moderation in business investment

(Thursday Post-Fed Meeting) The table appears set for one more Fed rate hike this year after the central bank elected Thursday to keep interest rates unchanged for now. The economy continues to fire on most cylinders, according to the Federal Open Market Committee (FOMC), though the FOMC’s statement did note that business investment has begun to moderate.

What’s really in question is how the Fed might proceed next year, especially in light of a U.S. economy that continues to charge forward even as many overseas ones look tepid. Generally, the Fed’s decision and statement indicate that the economy remains healthy, and puts the Fed in a perfect spot to raise rates next month.

No Surprise Party Today

Today’s decision probably didn’t surprise many investors. Going into this week’s meeting, the Fed funds futures market was flashing about a 7% chance of a rate hike. After Thursday’s non-decision, the target range for the federal funds rate remains between 2% and 2.25%. That’s the highest it’s been since the Great Recession a decade ago, but just barely into the 2% to 5% range where the Fed has historically kept rates.

All eyes now to turn to next month’s meeting, which concludes December 19, just ahead of the end-of-year holiday period. Immediately after the non-decision Thursday, Fed funds futures inched back slightly to show just under an 80% chance of rates moving at least 25 basis points higher between now and the end of the year. If the Fed does hike again before 2019, it would be the fourth of the year, and the ninth since the Fed started raising rates from effectively zero in December 2015.

Even as rates steadily rose over the last three years, the economy kept gaining. Inflation has gone from barely being a factor in 2015 to hitting the Fed’s target of 2% (based on Personal Consumption Expenditure, or PCE, prices as of August). While this happened in the U.S, overseas economies—including China and Europe—recently started to show signs of slower growth.

That puts the Fed in a tough place as it tries to keep the U.S. economy from overheating even as it faces pressure not to run the value of the dollar so high that it might hurt foreign countries and keep their consumers from being able to afford U.S. products. Remember, the Fed has a dual mandate of stable prices and maximum employment. There are signs that a stronger dollar, along with recent trade battles, might be hurting U.S. company outlooks.

The stock market, which had been swinging back and forth around unchanged most of the morning, didn’t seem to have much of an immediate reaction to the Fed decision, but began moving lower about half an hour after the news. That could reflect in part the Fed’s language about moderating business fixed investment (see below). In Treasuries, the 10-year benchmark yield rose slightly to 3.23%, just a few basis points below last month’s highs.

Policy Drivers

The Fed’s statement Thursday didn’t evolve much from its last meeting in September. As it did then, the Fed noted “economic activity has been rising at a strong rate,” and “job gains have been strong.” It added that the unemployment rate has dropped, and that household spending has “continued to grow strongly.”

The one significant change was around business investment, and that follows what looked like a slowdown in that category in the Q3 gross domestic product (GDP) report issued last month.

“Growth of business fixed investment has moderated from its rapid pace earlier in the year,” the Fed’s statement now reads. Back in September, the Fed’s statement said that the category had “grown strongly.”

On the inflation front, there was no change to the Fed’s September prediction that price increases would remain near its 2% target over the next 12 months both for overall inflation and core inflation that strips out food and energy prices.

The Fed’s statement follows another quarter of strong U.S. economic growth, with gross domestic product up 3.5% in Q3. Also, the unemployment rate sits near 50-year lows at 3.7%, and wages rose 3.1% in October. All of these data could argue, at least to some, for a continued hawkish Fed. Some analysts even expect four rate hikes next year. The market’s average estimate, however is for 2.5 rate hikes in 2019, according to Fed funds futures.

That said, there are signs of slowing momentum in some sectors. Many housing-related stocks remain under pressure as higher mortgage rates and climbing home prices might be keeping some people out of the real estate market. A number of major companies, including Apple (AAPL) and Amazon (AMZN) gave holiday quarter outlooks that seemed to disappoint Wall Street. Many materials and industrial companies warned that a higher dollar and tariffs might put their business under strain in the coming year. The Fed is probably paying close attention to all of this, and it’s likely to influence policy as 2019 gets underway.

In Q3, U.S. business investment grew at just a 0.8% annual rate, the government said. That included a contraction in investment in business structures, which had been running strong for months, thanks to spending on oil and gas rigs driven by rising energy prices, The Wall Street Journal reported at the time. It added that some companies might be pulling back investment in the face of tariff fears as the U.S. and China continue to clash over trade policy. This remains a possible factor to watch, and the Fed likely will be watching it closely.

A Nod to Recent Volatility

The Fed’s decision to hold rates steady comes after a wild ride in October and early November that took the S&P 500 (SPX) into correction territory (down 10% from highs) at times before stocks roared back in the last week. The rising rate environment and concerns about how higher rates and a rising dollar might play into next year’s earnings and economic outlook might have played a part in pushing stocks down last month. Also, the downturn came in the immediate aftermath of Fed Chair Jerome Powell saying in early October that the central bank is a “long way” from reaching a neutral rate environment.

That speech seemed to hold out the chance for the Fed remaining pretty hawkish in the near term, and might have been a blow to any bullish investors who’d been hoping for a hike hiatus or at least a slow-down in 2019. Powell didn’t say at the time what “neutral” might mean, and analysts are all over the map on where a neutral level could be. The Fed’s most recent “dot plot” from late September shows officials coalescing around a possible rise in rates to just above 3% by late next year from the current range of 2% to 2.25%, rising to around 3.6% by late 2020. That would imply at least two to three more rate hikes in 2019 after the anticipated fourth 2018 rate hike next month.

Powell Back on Stage Next Week

Next Wednesday afternoon might bring more perspective on what “neutral’ might mean when Powell speaks at a Dallas Fed event called, “Global Perspectives with Jerome Powell.” Investors might want to consider watching that event’s “moderated conversation” featuring Powell and the Q&A that follows for more clues into his thinking, especially since there’s no press conference associated with today’s meeting.

The Fed decision arguably removes another source of market volatility from the equation. The Cboe’s VIX, which is the most closely watched “fear index,” has been on the decline since a near-term peak above 26 in late October. Still, it’s hard to believe the Fed meeting played a big role in the recent choppy markets. More likely, volatility could continue in coming weeks ahead of President Trump’s meeting later this month with Chinese President Xi, where trade relations are likely to be a topic. Trade continues to arguably be the top issue for investors to consider watching, especially now that the U.S. election and the Fed meeting are out of the way. Some of Wednesday’s post-election rally might have reflected investor hope that the divided power structure soon to take effect in Washington might make the administration more likely to try to reach a deal with China before the new year when the makeup of Congress shifts, but that’s pretty much speculation.

One thing to consider about the market’s October shakeup, which occurred despite what the Fed continues to see as a strong economy: Sometimes there’s a disconnect between what’s going on with the government’s economic numbers and the stock market, because the numbers are backward looking and the market looks forward. However, over time the disconnect can grow narrower, and that might be underway now as the market charges back amid continued firm economic data.

FIGURE 1: 10-YR YIELD RISING. After topping out just below 3.25% in early October, the yield on the 10-year drifted down to just above 3% amid October volatility. Post-election, the yield moved back to the upside. Data Source: Cboe. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Balancing Act: Before the financial crisis hit in 2007, the Fed maintained a balance sheet of about $870 billion. That topped out at $4.5 trillion by the end of 2014 as the central bank tried to stimulate the economy with ultra-loose monetary policy. That’s slowly been normalizing. But at a rate of $400 billion a year, it would take 10 years to get down to where it was pre-crisis. That assumes no recessions, no worldwide banking crises, nor any reason the Fed may have for upping the size of the assets on its books. Does it matter? Some, including former Fed Chair Ben Bernanke, say a larger balance sheet increases the amount of "safe" assets in the financial system. Others, however, express concern that the Fed’s intervening in markets such as government bonds and mortgage backed securities, as it did during the quantitative easing period, can impede a freely-functioning private market, distort prices, and pick "winners and losers."

Fed Rate Trajectory: Based on the futures market, traders seem pretty sure that the Fed will raise rates in December, and they appear fairly confident of another hike in March. Shortly after today’s announcement the futures market was showing a 78% probability of at least a 25-basis-point hike by December and a 60% chance of at least two hikes of the same magnitude by March. The Fed’s latest so-called dot plot, from September, suggests the possibility of two or three total rate hikes in 2019.

Musical Chairs: The Fed’s interest rate setting body, called the Federal Open Market Committee (FOMC), isn’t static. Of the 12-member committee, four slots are filled by Fed presidents who serve rotating one-year terms while the New York Fed president always gets a vote. (There are currently three vacancies on the Fed’s board of governors, which is supposed to have seven votes, leaving the current FOMC with only nine voting members.) This year’s outgoing presidents are Richmond’s Thomas Barkin, Atlanta’s Raphael Bostic, San Francisco’s Mary Daly and Cleveland’s Loretta Mester. They’re scheduled to be replaced by Chicago’s Charles Evans, Kansas City’s Esther George, Boston’s Eric Rosengren and St. Louis’ James Bullard. The incoming presidents are split evenly on their monetary policy views, with Evans and Bullard considered dovish and Rosengren and George considered hawkish. Meanwhile, Richard Clarida is a new vice chair of the board of governors. Congress has not confirmed President Trump’s three nominees to the vacant spots on the board. We’ll have to wait and see if the FOMC’s new composition, once all is said and done, makes the committee more hawkish or dovish, or leaves its overall stance unchanged.

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